Working capital management

Companies have limited amounts of resources. Therefore, it is essential to take care of the allocational efficiency of capital markets, and make sure that resources will be organized in the most productive way (Arnold, 1998). This is a common view in the literature of finance, and even if the statement originally concerned stock markets, the same idea serves as a foundation behind the management of working capital in companies and financial supply chains: working capital should be allocated in the most optimal way, and released in order to use it for more productive objectives. This calls for the reasonable reduction of working capital in the supply chains, but also for the optimization of the working capital inside the value chain. This would improve financial flexibility, as well as decrease financing costs (de Almeida and Eid Jr., 2014).

Research in the area of working capital management has increased recently. The origin of the research is in finance. However, working capital is not a mere financial concern:

the key to its improvement lies in the operative actions behind the financial results (Reilly and Reilly, 2002). Thus, during the past decade, working capital studies under the research stream of supply chain management have increased as well. The bibliometric study by Viskari et al. (2011b) showed that, in the studied databases, the number of articles concerning working capital management was 23 during 1990–2010, and the number of annual studies increased in the last years of the observation period. The findings by Pirttilä (2014) confirmed this trend, as during the following 3-year period (2011–2013), 39 articles were published. Despite the increased number of scientific articles in general, the findings by Viskari et al. (2011b) and Pirttilä (2014) demonstrate the grown academic interest in working capital management. Although, it should be noted that only articles considering working capital management as a whole were included in the analyses, and papers concerning inventory management or trade credit alone were excluded. One reason for the grown interest in the working capital was the financial crisis of 2008, as it decreased the availability of trade credit (Kestens et al., 2012) as well as external financing from banks. The situation led to the increased interest in the opportunities to release working capital from the supply chain (Polak et al., 2012).

Another trend causing the increasing focus on the working capital issues are the new technologies enabled by the digitalization. It has been shown that high level of digitalization in companies enable the use of innovative supply chain finance solutions, which are more flexible and provide benefits for all participants (Caniato et al., 2016).

Digitalization can support the synchronization of material, information and financial flows in the supply chains, which provides benefits for the supply chain partners (Omran et al., 2017). With strong probability, the development of blockchain technology will affect the management of financial flows in the future (Iansiti and Lakhani, 2017).

Many researchers have studied the connection between effective working capital management and firm performance. The contexts of the studies have varied: in many studies, the sample has been restricted to a specific country or geographical area (e.g. de Almeida and Eid Jr., 2014; Padachi, 2006; Sharma and Kumar, 2011), certain industry sector (e.g. Shah and Sana, 2006; Viskari et al., 2011a; Tahir and Anuar, 2016), or to

2.2 Working capital management 33 manufacturing (e.g. Raheman et al., 2010) or service (Marttonen et al., 2013) companies.

Several studies have concentrated on the relation between working capital management and profitability in small and medium sized companies (e.g. García-Teruel and Martínez-Solano, 2007; Tauringana and Afrifa, 2013; Tran et al., 2017). Reasons for this particular interest may be the limited access of small firms to external finance (Tran et al., 2017), limited resources in terms of equipment and technology to manage working capital components effectively (Tauringana and Afrifa, 2013), and the crucial role of efficient working capital management in the growth and long-term survival of small firms (Pais and Gama, 2015). Generally, most studies about the connection of working capital management and firm performance have reported a significant negative correlation between working capital and profitability (e.g. Jose, 1996; Shin and Soenen, 1998;

Deloof, 2003; Lazaridis and Tryfonidis, 2006; Mojtahedzadeh et al., 2011; Marttonen et al., 2013; Enqvist et al., 2014; Yazdanfar and Öhman, 2014; Lyngstadaas and Berg, 2016). The same result was confirmed by Singh et al. (2017). In their research, they conducted a meta-analysis of 46 articles studying the relationship between working capital management and profitability to synthesize the previous quantitative research findings. The results support the traditional view that aggressive working capital management minimizing the inventories and accounts receivable, and maximizing the accounts payable, would lead companies to the best profitability.

However, opposite findings have been presented as well. The results by Abuzayed (2012) indicated that more profitable firms in Jordan were less motivated to manage working capital. The studies in India (Sharma and Kumar, 2011) and Pakistan (Nazir and Afza, 2009; Tahir and Anuar, 2016) also found a positive relation between working capital and profitability. This could indicate that the operating logic in regard to working capital management is different in the emerging markets. Baños-Caballero et al. (2012, 2014), Aktas et al. (2015) and Pais and Gama (2015) have provided evidence for the existence of an optimal level of working capital. The results showed that companies can maximize their profitability with a certain level of working capital, but moving away from the optimal level by decreasing or increasing the tied-up working capital deteriorated profitability. The results presented above indicate that even if demonstrated with several studies and datasets, the positive correlation between profitability and working capital efficiency is not unambiguous. Individual companies have to take into account which working capital management practices improve their profitability and not simply blindly aim at decreasing their working capital.

2.2.1 Inventory management

Especially in a manufacturing company, inventories may tie up remarkable amounts of cash into the inventories of raw material, work-in-process and final goods. Thus, efficient inventory management is a highly important part of working capital management, and the component of working capital that can mostly be affected by the company itself. On the other hand, it can also be seen as the most difficult working capital component to manage as it requires involvement from several functions, such as production, purchasing,

finance, management, sales and engineering (Björk, 2000). Rafuse (1996) argues that companies should direct their working capital management attention particularly on the reduction of inventories, as the benefits gained via more efficient inventory management are real and substantial, and not caused by re-allocating working capital in the value chain.

The optimal amount of inventory is balancing between the disadvantages of inventories too large and too small. Carrying large inventories requires a lot of physical space, ties up working capital, and increases the risk of damage, spoilage, and loss, whereas inventories that are too small may cause production stops and lead to negative effects on customer service (Koumanakos, 2008) and further, to lost sales (Shin et al., 2015).

Traditionally, studies on inventory management have concentrated on the efficient operations and correct sizing of inventory in relation to economic order quantity (EOQ), management philosophies like just-in-time (JIT) and lean, and issues in demand characteristics and marketing environment (Koumanakos, 2008). Logistic researchers have developed models for inventory control and studied collaborative inventory management (Williams and Tokar, 2008). One of the collaborative tools for inventory management is the vendor-managed inventory (VMI), which has been the topic of several studies (e.g. Yu et al., 2012; Mateen and Chatterjee, 2015). The VMI is based on a collaborative strategy and information sharing between a customer and supplier, and it is a process in which the supplier manages and replenishes the raw material inventory of the customer at the warehouse level (van Weele, 2010). VMI is used to optimize the availability of material at minimal cost for both actors, and its benefits are the reduction of total inventory costs and the ability to manage the bullwhip effects in the supply chain (Karimi and Niknamfar, 2017). In an individual company, inventory management can be made more efficient by short- or long-term actions (Steinker et al., 2016). Short-term actions include the optimization of inventory policies, reduction of obsolete stocks, and enhancement of forecasting processes. Re-designing the manufacturing network, reduction of portfolio complexity, and supplier integration are considered as long-term actions. The study by Steinker et al. (ibid.) showed that companies under financial distress use short-term inventory adjustments to free tied-up working capital.

While the principles of lean and JIT have become more popular, the value of more efficient inventory management has been understood in companies and thus, inventories have decreased during the past decades. Chen et al. (2005) studied the changes in inventory management with a large dataset consisting of American manufacturing companies, and found a significant reduction in the cycle time of inventories, which decreased by 15 days over the observation period from 1981 to 2000. The reduction was mainly due to reductions in the work-in-progress inventories, whereas the inventories of finished goods remained at the similar level. Additionally, the authors found abnormally high inventories leading to abnormally poor long-term stock market performance, while abnormally good stock market performance was achieved by companies with low, but not too low, inventories. A similar finding was made by Eroglu and Hofer (2011), who suggest that going too lean on inventories (i.e. reducing inventories too much) is not beneficial, but may turn negative. They found evidence for the existence of an optimal

2.2 Working capital management 35 degree for inventory leanness, and when the inventories are reduced beyond that limit, it has a negative effect on firm performance.

Many other researchers have studied the relation between inventory management and financial performance as well. Claycomb et al. (1999) concluded that companies following JIT gained improved financial performance in terms of profitability and return on investment and sales. Capkun et al. (2009) found a significant positive correlation between inventory and financial performance. According to their findings, there are industry-specific differences in the impact of different inventory types on operating profit.

Their findings indicate that while in the assembly-related industries operating profit is improved by reducing all types of inventories, processing industries or basic commodities do not benefit that much from the reduction of raw material or work-in-process inventories. Another positive relation was found by Shin et al. (2015), whose findings also indicate that small companies were able to gain even more advantage of reduced inventories than medium and large sized companies. Negative relation between inventory efficiency and financial performance has been found as well. Balakrishnan et al. (1996) analyzed the annual reports of 92 manufacturing companies and studied the relation between different inventory types and profitability. Their results showed that efficient inventory management was not associated with a superior return on assets. Cannon (2008) found only a little or no link between the improvements in inventory management and overall financial performance in his study of 244 firms over a 10-year observation period.

He points out that improved inventory performance should not be considered as the only indication of improved overall performance.

2.2.2 Trade credit management

The other part of operational working capital, trade credit, consists of the financial flows towards the supplier (accounts payable) and customer (accounts receivable). Trade credit has been recognized as an important source of short-term finance (Nadiri, 1969; Petersen and Rajan, 1997; Seifert et al., 2013), and it has been widely used in practice (Luo and Zhang, 2012). Trade credit arises when goods are sold on credit. The use of trade credit creates accounts receivable for the supplier which is equivalent to the amount of accounts payable created to the customer. The reasons for the use of trade credit are various:

competitive and industry pressures, substitution or complementation of bank credits, or reduction of transaction costs (Petersen and Rajan, 1997; Seifert and Seifert, 2008; Seifert et al., 2013). The study by García-Teruel et al. (2014) showed that SMEs use trade credit to finance their sales growth. Mateut et al. (2015) found evidence that firms with large raw material inventories used trade credit to sell goods to their customers in order to reduce inventory costs. The study by Ng et al. (1999) revealed that credit terms seem to differ between industries, but within the industries only a little variation was found. There are also country-specific differences in the use of trade credit (Seifert et al., 2013).

A major part of previous research on trade credit comes from finance (see e.g. Petersen and Rajan, 1997; Molina and Preve, 2009; Fabbri and Klapper, 2016), but recently, studies in the area of operations and supply chain management have also been made (see

e.g. Lee and Rhee, 2011; Luo and Zhang, 2012). As trade credit is a component affecting more than one company – accounts payable of the buying company are accounts receivable of its supplier – it makes sense to view the situation from the supply chain perspective as well. Also, Seifert et al. (2013) highlighted the relevance of the supply chain perspective and raised a question of how to use trade credit for allocating capital through the supply chains. Lorentz et al. (2016) studied trade credit dynamics in the context of a value chain. Their findings show that the change in the cycle times of trade credit components seems to react to the economic situation, and they found evidence of passing extensions in the cycle time of accounts payable upstream along the value chain.

This affects the cycle time of accounts receivable in the value chain as well. Their finding supports the previous results by Bastos and Pindado (2013), which indicated that companies carrying large amounts of accounts receivable delayed their payments to suppliers in order to avoid the risk of insolvency.

Lorentz et al. (2016) suggested collaborative cash management to be considered as a way of improving the value chains as a whole. This view is shared by other researchers as well. The collaborative perspective emphasizes that large companies should not use their power to stretch the accounts payable periods at the expense of suppliers – the behavior that was identified in the study by Fabbri and Klapper (2016) – but instead, consider the advantage of the supply chain as a whole. Kroes and Manikas (2014) found that the reduction of accounts receivable was positively associated with firm performance, but changes in the accounts payable are not related to changes in performance. They argue that the increase of accounts payable only offers improvements to immediate liquidity, but on the long-term it may have a negative impact on the firm. Huff and Rogers (2015) made a longitudinal study on the relationship of the working capital components and financial performance of a firm. They found that payment term adjustments only give short-term benefits, but improvements in inventory management offer longer-lasting advantages for a company. Similarly, Grosse-Ruyken et al. (2011) and Wandfluch et al.

(2016) also stated that by forcing supply chain partners to accept longer payment terms a firm can only achieve short-term success.